What is undercapitalization? What are the causes of undercapitalization?

What is undercapitalization? What are the causes of undercapitalization?

Under capitalization is any situation which restricts the business companies to acquire the funds which they need. Under capitalization is also a state like over capitalization where the owned capital of the business is much less than the borrowed capital. It also means that the owned capital of the company is not up to the scale and its operation and business depends on the borrowed money. This also comes as a result of over-trading. Under capitalization has many factors involved with it and it is indicated by:

(i) Low proprietary Ratio

(ii) Current Ratio

(iii) High Return on Equity Capital

The effect of undercapitalization can be summarized as:-

(i) The payment of excessive interest on borrowed capital can lead to under capitalization as we have to pay more interest on the capital which has been borrowed from some other dealers around.

(ii) Under capitalization can also cause companies to use their old and out of date equipment because of inability to buy new items or purchase new items.

(iii) Under capitalization allows the companies to run on low cost because of that they are unable to have high cost of production due to use of old machinery. It is also a cause of improper financial planning. It is difficult to raise the capital if any company comes under this sort of situation. There are several different causes that exist such as:-

- It makes a company growing financially with short-term capital, rather than having permanent capital to spend on goods and on purchasing.

- It doesn't allow a secure transaction of bank loan at critical time.

- In during the predictable business risk it also fails to obtain the insurance cost.

This is when the company's actual rate is much higher than the general rate of earnings in the industry of trade. Thus, the market value would be much higher/ the price share would be much higher than the market value of similar companies in the same trade.

The causes are significantly seen to be the under estimating the company's initial earnings; The maintainance of high standards of efficiency in company operating; Creation of adequate reserves to cater for depreciation. For instance, large plough backs of profits resulting in surplus or more than adequate available funds for expansion and growthThis susbsequently results in management manipulating the share priceEncouragement of competition emanating from new companies entering the industry as they get attracted.The workers may demand a higher pay riseThe consumers may feel exploited.However, there are remides which incorporates the issue of bonus shares or raising par value shares.